An Ode to Deflation

Let's talk about Japan, whose 20-year battle with bubbles, deflation, stagnation, aging demographics and massive debt may just be presaging what the West may experience soon.

The working assumption of economists far and wide is that deflation is bad, that it caused the Great Depression and if we can just avoid deflation, depression will also be avoided. I have come to question this most basic of all assumptions and believe that the pursuit of avoiding deflation at all costs is in fact the cause of the economic stagnation that Japan has experienced for 20 years (and the West for 10).

Rather than assigning false causality (at the start of the Depression there was deflation, therefore deflation caused the depression) consider why deflation may occur and what it can accomplish. Deflation seems to be considered a market failure, but why is that? If economic conditions have changed substantially, due mainly to extensive, technology-driven productivity improvements that structurally eliminate the need for many jobs, why is the natural adjustment of the markets considered erroneous?

A better analysis is to realize that deflation both corrects structural issues and lays the foundation for creation of new wealth. New jobs will only be created by new business formation. New business formation is enabled by the sudden affordability of resources. For instance, starting a website in 1992 would cost hundreds of thousands, if not millions, of dollars. By the 00s, this resource was so cheap that Facebook could get up and running with an investment in the tens of thousands. Similarly, people that would command unaffordable salaries are suddenly affordable when unemployment is high, enabling start-ups to acquire the talent needed to grow.

Now, the unemployed are not happy to command far less in earnings than they did previously, but in a deflationary environment this is less of a problem because the necessities of life are also far cheaper. Deflation enables the inexpensive resources that new businesses need to get started, without creating excess hardship on those resources. Artificial intervention to prevent deflation blocks the natural process that frees resources for new business formation. This is the single most important reason that fighting deflation is a deadly, wrong policy decision.

Economists argue that deflation raises the real value of debt, so that debtors have a higher burden of repayment. True enough. But consider that in an economic collapse, many of the assets of creditors are wiped out in defaults. This is also a severe economic burden, but deflation helps creditors recover some of their assets. The value of what they have left is higher, easing some of the pain of bad debts.

Essentially, deflation reduces the impact of economic collapse. Creditors will suffer, but not as completely as when the defaults are not offset. The unemployed are relieved of the full lifestyle impact of their reduced earnings power. And purchasing power relative to foreign imports increases substantially, also augmenting effective incomes. And, deflation enables more rapid new business formation, helping to more quickly redeploy resources, reducing the burden of unemployment.

Japan has suffered for 20 years because they pursued an aggressive policy to fight deflation. Instead of having prices collapse over the course of two or three years, then resuming growth in a reorganized economy, they printed massive amounts of money, resulting in a slow, dripping deflation of a few percent a year. Japan has not suffered 20 years of stagnation because of deflation, they have suffered because they have fought it. The fight against deflation in the West will continue unsuccessfully and cause us the same decades of stagnation that Japan has experienced.

What does this mean for your portfolio? Understanding the fundamental policy mistakes of the Federal Reserve means you can profit from them. Because they cannot defeat deflation -- because defeat means they are only defeating the self-correcting mechanisms that would normally enable the economy to start growing robustly -- you can bet on several years more of anemic economic growth. You can also bet on several years of accelerating QE, which will eventually cause more dollar debasement, which argues for using gold as your cash substitute. You can also bet on accelerating debt issuance by the federal government, similar to Japan, but following their example, may not cause higher interest rates as one would expect. I think the surprise is that rates stay low for quite some time.

Japan is the playbook that will repeat, as our mistaken and unobservant monetary policymakers execute an uninformed war against deflation.